Last year was supposed to be when the cannabis industry proved to Wall Street and investors that it deserved a lofty valuation. Canada had recently become the first industrialized country in the modern era to legalize recreational weed and was seemingly months away from launching higher-margin derivatives, while the U.S. appeared to have plenty of momentum with regard to additional state legalizations.

But when 2019 came to a close, investors' hopes had faded, and marijuana stocks ended the year considerably lower. Most people would point to Canada and its supply issues as topping the list of marijuana disappointments that sacked the promising pot industry. However, just as much blame, if not more, deserves to be placed on the biggest marijuana market in the world by annual sales: California.

The fact is that California is failing its cannabis industry in a variety of ways.

A green highway sign that reads, Welcome to California, with a white cannabis leaf in the upper-right corner.

Image source: Getty Images.

California's taxation and overregulation are crushing its pot industry

To begin with, it's taxing the daylights out of its consumers. Whereas Canada attempted to get aggressive in driving out its black market by imposing only a 10% excise tax on dried flower, Californian pot consumers can expect already high state and local sales tax, a 15% excise tax, and a wholesale tax that depends on the state of the product (i.e., whether it's in flower form or leaf form) to be imposed on their purchase. Additionally, there are other expenses being factored into the final price of pot products, including quality testing, which is often done at the distribution level. It would not be surprising if the aggregate impact of these various levels of taxation and regulation were adding 50% (or more) to the final price of the product.

Were this not enough, the California Department of Tax and Fee Administration announced in November that the taxation levels of cannabis products would actually rise on Jan. 1, 2020. A recalculation of the markup rate at the wholesale level from 60% to 80%, as well as inflationary increases to the wholesale cannabis tax, will place an even greater burden on consumers in the Golden State. This makes it virtually impossible for legal retailers to compete with the black market.

Regulations have also been a serious concern in California. On the one hand, some jurisdictions have been slow to approve dispensary licenses. For instance, in November, the Los Angeles City Council requested that the assignment of 100 dispensary store licenses within the city be redone. The Council argued that some of the awarded applicants had an unfair advantage by being able to access the online application early -- the end result being that far too few dispensaries are currently open more than two years after the state opened its doors to adult-use sales.

On the flip side, the passage of Proposition 64 still allowed jurisdictions the final say as to whether or not they'd allow recreational sales in their cities. In California, roughly 80% of the state's jurisdictions have said no to cannabis stores setting up shop for adult-use sales. This, along with the dispensary license delays, has further allowed the black market to thrive.

A drug free zone street sign in a quiet neighborhood.

Image source: Getty Images.

It could even be argued that the Golden State isn't doing nearly enough to filter out this illicit presence. Even with California authorities seizing an estimated $1.5 billion worth of wholesale cannabis in 2019, worth roughly $3 billion at the retail level, black-market pot sales outpaced legal revenue by a ratio of nearly 3-to-1 (an estimated $8.7 billion versus an estimated $3.1 billion for legal weed in 2019). 

California-focused pot stocks are feeling the pain

As you might imagine, a state that's forecast to account for perhaps 25% of all U.S. sales by 2024 is bound to attract a lot of attention from vertically integrated operators. Unfortunately, this attention hasn't panned out for a number of pot stocks, at least in the early going.

For instance, MedMen Enterprises (MMNFF) was one of Wall Street's hottest cannabis stocks when it debuted as a public entity in 2018. Its sales per square foot at its existing Southern California locations rivaled that of Apple stores, earning it the nickname the "Apple of cannabis." But in recent quarters, MedMen has seen its operating results and balance sheet deteriorate.

In California, MedMen has opened more than a dozen retail locations, with sequential quarterly growth in these locations having slowed to the 5% to 10% range. This might sound decent, but it's nowhere near the exponential growth expected in the Golden State, especially with MedMen aggressively opening locations both in and outside of California. This sales weakness is a big reason why MedMen wound up losing almost $232 million on an operating basis in fiscal 2019. Now faced with a serious cash crunch, the company's future is very much in doubt.

A large cannabis dispensary sign in front of a retail store.

Image source: Getty Images.

California's issues have also put pressure on multistate operator (MSO) Cresco Labs (CRLBF -6.98%), which recently completed its all-stock acquisition of Origin House. Unlike most MSOs, which have been trying to push into as many states as possible and build their retail presence, the Cresco Labs deal was unique in that it was almost exclusively aimed at California. You see, Origin House is one of California's relatively few cannabis distribution license holders, and the deal now allows Cresco Labs to get its products into more than 575 California dispensaries. Of course, with tax rates remaining high and a majority of cities banning marijuana retail stores, Cresco's revenue boost may not be as impressive as first envisioned.

For what it's worth, California Gov. Gavin Newsom, a Democrat, has proposed a handful of changes in his latest budget proposal, including a simplification of the tax-collection process. He and his team are also taking into consideration the possibility of lowering the existing tax rates on legal products in order to make them more price-competitive with the black market. For now it's all hearsay, but it's clear that something needs to be done if California is going to live up to its billing as the most lucrative marijuana market in the world.